Stockbrokers are taking advantage of their privileged position to increase profits for favored investors and hedge funds, all at the expense of their other customers, new research suggests.

A team of economists has found evidence that brokers routinely leak confidential information about large stock trades to their best, most lucrative clients. When a savvy activist investor submits a trading order through a brokerage firm, for example, the brokers will exploit this information by telling their favorite clients all about it. Those clients can then imitate the activist’s strategy, thus earning higher returns themselves—to the detriment of the rest of the market, which was not privy to the leak.

“It’s a huge issue, because it hurts the investors who try to implement their investment ideas and puts the smaller asset managers at a disadvantage,” says Marco Di Maggio, an assistant professor in the Finance unit at Harvard Business School. “Furthermore, it might even be illegal.”

“Some managers appear to free-ride on the information provided by stockbrokers about the best ideas of other investors”

“Our findings highlight that an important source of returns for fund managers in the stock market is not their superior skill or investment acumen,” the authors write. “Rather, some managers appear to free-ride on the information provided by stockbrokers about the best ideas of other investors, which in turn is acquired thanks to the brokers’ ability to observe order flow before the rest of the market.”

Stockbrokers are intermediaries who buy and sell stocks for retail and institutional clients, either for a fee or commission. While their role in the market has received little public scrutiny, the research suggests that more scrutiny is warranted.

“This paper shows that brokers indeed play a key role in shaping information diffusion in the stock market,” the authors write.

To gain insight into broker behavior, the authors studied a large dataset of stock trades by institutional investors (such as hedge funds, mutual funds, and pension funds) from 1999 to 2014. The information came from Abel Noser Solutions (formerly Ancerno Ltd.), a firm that performs transaction cost analysis for institutional investors—and then makes it available to academics nine months later.

Damning information from an SEC form

The researchers also collected information from the Security and Exchange Commission’s Schedule 13D forms for the same time period.

And here’s where the potentially shady broker activity starts to become clear.

A Schedule 13D is a form that investors must submit to the SEC within 10 days of buying a 5 percent (or greater) stake in a company. It’s a legal requirement, which, like many disclosure requirements, is meant to level the playing field. Once that form is filed, everyone knows which firm an activist investor is targeting.

The market tends to react positively to the news of a new 13D. As the authors explain in the paper, “activists’ target companies tend to experience significant price changes once the activists’ strategies are released.” In other words, the stock price of the target company goes up.

Until that form is filed, only two parties are supposed to know about the trade order: the investor who initiated the transaction, and the broker who orchestrated it. But, the evidence suggests that brokers tend to spill the beans to their other clients before the form is filed.

To gauge whether brokers indeed were blabbing information about activist investor activity, the researchers looked at the trading activity in the 10 days preceding the 13D filing. If a broker orchestrated the trades for an activist, did that broker’s best clients soon follow suit? “If brokers were releasing information about their order flow, we should expect other traders to buy the stock of the target company before the 13D is filed, which is when the information is released to all market participants,” the authors explain in the paper.

Sure enough, in the 10 days preceding a 13D filing, a broker’s best clients—institutional investors who routinely paid high commissions or made large orders—were 10 percentage points more likely to buy the target company’s stock than they were in the month following the 13D filing—that is, once everyone knew the activist had acquired a stake in that company. Meanwhile, the broker’s other, smaller clients were more likely to sell that company’s stock in the days preceding a 13D filing, which suggested that they had no idea an activist investor was about to boost the stock price.

Of course, it’s possible that the activist investor could be the one leaking the information in order to drum up interest in the target company. But, in general, Di Maggio says, it behooves the activist to keep the trade on the down low, so as not to drive up the stock price while the trade is still in play. Even if activist investors told other investors about their plans, there would be a low likelihood that all those other investors would just happen to coincidentally use the same broker to piggyback on the information.

On the other hand, it makes a lot of logical, strategic sense for a broker to leak the information.

“The price you end up paying is not the best possible price”

“If I’m the broker, then I know an order, and I know how this will impact the price; what I can do is use this information to generate more and more commissions from my best clients,” Di Maggio explains. “And that’s what we see in the data: a quid pro quo between the broker’s best clients—who get rewarded for their past business with the information, and the broker—who earns higher fees by executing their piggyback trades. This behavior of the brokers is not confined to activists’ trades but systematically occur for informed trades: that is, any time the ‘smart money’ changes their stock positions.”

Why it might be illegal to leak order flow information

Leaking information about stock trades might be both unethical and illegal, Di Maggio maintains, due to a fiduciary duty called “best price execution.”

As the Securities and Exchange Commission explains on its Fast Answers page, “Brokers are legally required to seek the best execution reasonably available for their customers' orders.”

If brokers leak information about the trades they execute, they end up causing a price disadvantage for the investors who ordered those trades. That’s because these transactions are deliberately executed slowly, so any information leaked during that time may end up affecting the stock price before the transaction is completed.

“The price I give you is supposed to be the best price on the market,” Di Maggio explains, again taking the hypothetical role of the broker. “But, if you come to me with an order, and then I start telling all my best clients what you’re trying to do, they’re going to do it as well, which will push the price up. So the price you end up paying is not the best possible price.”

Notably, the researchers found no evidence of information leakage in cases where the activist investor and the broker belonged to the same institution, indicating that the brokers might know that a leak might negatively affect investors.

Where are the regulators?

If brokers are engaging in illicit activity, why haven’t regulators noticed? “For the same reason that many illegal activities have not been noticed before,” Di Maggio shrugs. In other words, they haven’t been looking.

The researchers recently presented the paper at the SEC. Although it’s not yet clear what direction the agency will take under the new chairman, Jay Clayton, who was sworn in May 2, Di Maggio is hopeful the agency will give due attention to the data.

Specifically, he’d like to see clarification of what constitutes legal versus illegal behavior with regard to chatty brokers.

“There is a gray area that the brokers are navigating,” Di Maggio says. “Because it’s not clear how much information is too much information. For example, if I don’t say that it’s Fidelity that made the large order, if I just say, ‘oh, I think there’s a lot of interest in this stock today,’ is that illegal? Well, maybe not. So, then, maybe there is sort of a gray area where they can navigate and continue doing this without breaking the law. But if the SEC could clarify this gray area, that would be important.”